4. The Cost of Capital Part 1

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Central to income-based valuation is the cost of capital, which represents the required rate of return for an investor. In this lesson, I show you how to calculate the weighted average cost of capital for MarkerCo.

- The cost of capital represents the required return for investors in an asset
- Understandably, the cost of capital for debt is very different to the cost of capital for equity
- When discounting cashflows, we use the weighted average cost of capital (WACC)

Weighted Average Cost of Capital (WACC)

- Calculates the cost of capital for both debt and equity
- Weights these values, based on the market value of the firm's equity and debt
- Provides an acceptable discount rate for cashflows that will calculate Enterprise Value

In previous courses, you may have heard me explain a concept called the time value of money and discounting future cashflows. Essentially, to calculate the value of an asset, we forecast future cashflows, and then discount these cashflows by the discount rate before adding the discounted cashlfows together to calculate our net present value.

The same principle applies when valuing companies. We calculate the future cashlfows for the company, and then discount these cashlfows back to a present value. But what should this discount rate be? This is one of the most contentious questions in finance and it's important because the discount rate you use can dramatically change your valuation of a company. For businesses we have the added complication of debt and equity. Which will have different discount rates. Analysts often disagree how the discount rate is calculated and it's important, when valuing a business, to stand over your discount rate assumptions. While analysts disagree often on what the correct discount rate for a company is, at least they do use the same concept called the Weighted Average Cost of Capital. Form an investors perspective, the cost of capital is the required rate of return by those investing in the business. Needless to say, the required rate of return for a debt holder is different to that of an equity holder. And the weighted average cost of capital simply calculates the weighted average for both the debt and equity investors in the company. So let's take a look at the formula for calculating the weighted average cost of capital. There's quite a few variables, so what I'll also include is my definition for each of these variables. So the weighted average cost of capital is equal to the cost of debt, multiplied by one minus the tax rate. This is then multiplied by a fraction, which is the market value of the debt, divided by the market value of the debt, plus the market value of the equity. And so, this portion of the equation looks after the cost of debt. And then, the second portion of the equation, looks after the cost of equity, which is r e, and multiply it by the market value of the equity, divided by the market value of the debt, plus the equity. Let's now apply some values to this formula so you can see it in action for a fictional company. And for this fictional company, I'm going to assume that there's a cost of debt, or an interest rate payment, of 5%.

I'm also going assume that the corporation tax rate is based on the U.S. and 35%.

Because interest payments on debt reduce the amount of tax the company pays, the effective cost of debt is lower than 5%. And this is why we apply the one minus Tc value to the WACC formula.

The next part of our equation is debt divided by the market value of debt plus equity. I'm going to assume a debt equity ratio of 1:1. So half of my WACC will be based off the cost of debt and the other half will be based off the cost of equity. And I'm going to assume here that the cost of equity is 8%.

Using some simple multiplication, I'll run the calculation, and find that my WACC is 5.625%.

While this seems relatively straightforward, the most contentious aspect of this formula is the cost of equity. The cost of debt can be relatively easy to find for large companies who have bonds that are currently traded in reasonably liquid markets. However, for smaller businesses, the cost of debt can be more difficult to estimate. In many cases, the analysts will often use the cost of the last debt that was raised by the business as the current cost of debt. The cost of equity is even trickier because shares do not carry an explicit cost, like an interest rate. While equity does not have a specific, concrete price, like debt, it does not mean that the cost of equity is zero.

As a result, we need to apply more advanced analysis to calculate the cost of equity. Perhaps the most popular way of doing this is the capital asset pricing model. Which I'll show you in the next lesson.